Where evidence meets policy

Taxes and benefits – should we take the long view?

Most analyses of inequality and tax and benefit reforms are based on measures of individuals’ circumstances at a point in time, often a week or a month. Recent work by researchers Barra Roantree and Jonathan Shaw at the Institute for Fiscal Studies (IFS) argues in favour of adopting a longer horizon and highlights the difference this can make.

photo credit: John Keogh

Why might we want to look at horizons longer than a snapshot? First, differences across individuals at a point in time may provide a poor indication of longer-run circumstances. Taxes and benefits depend on a number of key characteristics, such as employment, earnings, health and family composition. These characteristics exhibit considerable short-run variability and also have marked age profiles. As a result, differences in earnings, for example, could simply reflect the fact individuals are at different stages of life.

In addition, individuals typically have the ability to transfer resources across periods of life (by saving and borrowing) and have some influence over future circumstances through decisions they make today (e.g. partnering and childbearing). Consequently, snapshot measures may not give an accurate impression of living standards, even in the short-run.

A longer-run perspective can substantially change our impression of the effects of the tax and benefit system.

Impacts on policy

Our report considers the difference that taking a longer-run perspective makes to several key issues of interest to policymakers:

the reach of the benefit system

the level of inequality

how effective the tax and benefit system is at redistributing from rich to poor.

Analysis is based on data from the British Household Panel Survey (BHPS), carried out annually between 1991 and 2008 and which collected a rich set of data from the same individuals each year.

Benefits and the family

Taking first the reach of the benefit system, the table below shows the average share of individuals in a family who report receiving a benefit at a snapshot, and the share who report ever receiving the benefit some time over the 18 waves of the BHPS data. The differences are substantial.

For example, while on average only 11 percent of individuals report being in a family claiming council tax benefit at a snapshot, just under a third of individuals are in receipt at some point over the full 18-year horizon.

The difference is even more striking when we look at long run receipt of a wider range of benefits. On average, around 17 percent of individuals report being in a family who receive one of the main means-tested benefits at a point in time, rising to almost half of individuals over the full 18 year horizon.

These estimates are likely to understate the true proportion of individuals affected for two reasons.

First, as with any survey-based data, there is under-reporting of benefit receipt compared to official statistics.

Second, our long-run measure is based on 18 snapshots and so will some benefit claims occurring between the dates survey is carried out. All this suggests that over the long run, a far greater proportion of individuals interact with the benefit system than a snapshot impression would suggest.

The results suggest that inequality is considerably lower over longer horizons. Using a common measure of inequality, the Gini coefficient, we find that it falls steadily as longer horizons are considered: the gross and net income Ginis fall respectively from 0.461 and 0.304 for a single year to 0.371 and 0.241 across all 18 waves (both declines of around 20%). The reason inequality falls as the horizon increases is that some of the variation in income across individuals at a point in time is transitory and will tend to average out when considering multiple years together.

Taking the long view

Finally, we examined how our impression of the redistribution done by the tax and benefit system changes as the horizon increases. A common measure of the impact of taxes and benefits on inequality is the Reynolds–Smolensky index of redistributive effect, which measures the extent to which the tax and benefit system redistributes income in a way that reduces inequality.

The index falls by about a fifth as the horizon under consideration increases from 1 to 18 waves, suggesting that the tax and benefit distribution is achieving less redistribution across individuals over longer horizons. The reason for this is that, as the horizon is extended, part of what the tax and benefit system does is effectively to redistribute across periods of life rather than across individuals.

These results demonstrate that a longer-run perspective can substantially change our impression of the effects of the tax and benefit system.

They also point towards the desirability of undertaking analysis from the perspective of full adult life cycles. Unfortunately, data on full lifecycles does not exist for the UK, meaning that estimation techniques would have to be used. Future research funded under the same grant from the Nuffield Foundation will attempt to do just this.

Barra Roantree is a Research Economist at IFS and Jonathan Shaw is a Senior Research Economist at IFS.

This work has been funded by the Nuffield Foundation under grant OPD/40976.